Rates of Return-Suppose a venture fund wishes to base its required return (used in discounting

QUESTION

Rates of Return-Suppose a venture fund wishes to base its required return (used in discounting future terminal values) on its historical experience and suggests merely averaging the rates on the last three concluded deals. These deals realized total returns of -67 percent at the end of two years, 50 percent at the end of five years, and 70 percent at the end of three years, respectively.A. Assuming no intermediate flows before the terminal payoff, verify that the associated annualized rates are -42.55 percent, 8.45 percent, and 19.35 percent.B. What is the equally weighted average annualized return?C. Does it make sense to use this as a single discount rate to apply across scenarios involving different durations?
Solution: A) Annualized rate = (1 + i)^(1/n) 1 Annual rate for first project = (1 .67)^(1/2) 1 = -42.55% Annual rate for second project = (1 + .50)^(1/5) 1 = 8.45% Annual rate for third project = (1 + .70)^(1/3) 1 = 19.35% B) Equally weighted average annualized return = Sum of (Return * Weight) = (-.4255*1/3) + (.0845*1/3) + (.1935*1/3) = -4.92% C. It does not make sense to use this as a single discount rate to apply across scenarios involving different durations. Because rate is dependent of maturity and risk

ed. If project is loner it is more risky and liquidity premium also need to be added to determine its discounting rate. Every project has different inherent risk and accordingly risk premium vary from project to project and accordingly discounting rate will also vary because discounting rate is determined after adding risk premium to the risk free rate.

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